The Math That Matters

The longstanding perception of mutual fund
investors is that they blindly chase short-term
performance, piling into last quarter’s
hottest funds and sectors. One problem with
this caricature is that it doesn’t jibe with
the well-established correlation between fund
flows and the Morningstar Rating for funds.
These star ratings, unlike the category
rankings that they displaced, are not based
on short-term raw performance but instead
focus on longer time periods and adjust for risk
and for cost. If asset flows correlate with
star ratings, then investors and their advisors
must be thinking longer term and paying
more attention to cost and risk than they are
given credit for doing.

Morningstar’s new research on money-weighted
returns, or what Morningstar calls Investor
Returns, reveals a fascinating insight into
what drives fund flows and further belies the
notion that investors naively chase shortterm
performance. In looking at the difference
in fund flows among major fund firms,
we found that there was a 19.6% positive
correlation during the 10-year period through
August 2011 between total returns and
fund flows relative to asset size at the 25
largest fund-management firms. This tells you
what you would expect—firms with better
performance tend to attract more money. It
further suggests that mutual funds are part of a
reasonably efficient system for allocating
capital. Money flows to the better managers,
who in turn allocate capital to better stocks.
If the correlation didn’t exist, and dollars simply
flowed to the best-marketed funds, then the
industry would be dysfunctional.

What’s interesting about this research is the
further exploration of the correlation between
flows and investor returns. Investor returns
estimate collectively how much money a fund
actually makes for investors. It weights
performance more greatly in periods where
more money is in the fund and conversely
discounts performance when the fund has less
money under management. It doesn’t
tell you what any one investor made, but it
gives you an idea not only how well the fund
performed but whether or not investors
managed to deploy the fund successfully.

Stunningly, the correlation between fund flows
and investor returns dwarfs that of the
correlation with total returns. We found a 49%
correlation of flows with investor returns
over this 10-year period, two and a half times
the magnitude of the correlation with
traditional total returns. What this tells us is
that investors aren’t chasing hot funds but
instead are behaving in a perfectly rational way.
They are returning to places that have produced
good investing experiences for them and
moving away from firms that have tempted
them to buy high. What fund investors really
want is a fair shake, not last quarter’s
performance darling. This notion is further
bolstered by the correlation we’ve seen
between Morningstar’s Stewardship Grades
and fund flows.

The idea that investors care mostly about
chasing hot funds is clearly false. Even
the correlation with longer-term raw performance
is only moderately strong. The
correlation that matters is what investors
actually experience. This insight has obvious
implications for fund companies—they
should shed short-term sales goals and instead
focus on being better stewards of capital.
It also has big implications for financial
advisors. While it’s impossible to track asset
flows among advisors, it’s axiomatic that,
because most flows into funds go through an
advisor, the trends seen at the fund level must
apply to advisors as well. In other words,
advisors who produce better investor returns
for their clients are more likely to see their
practices grow, even if their raw performance
numbers may lag flashier competitors.

What investors care about is meeting their own
goals. Most see money as a means to an end,
not as a contest to outgain their neighbor.
Advisors who focus on maximizing short-term
returns play to a small and very fickle subset
of the individual-investor community.
Those that take a longer-term, client-goalcentric
approach appeal to a broader and more
loyal demographic. Headlines like “7 Funds
to Buy Now” may garner web traffic, but that’s
not what resonates with serious investors.
Wise advisors have long built their practices
along this insight, which flies in the face of the
perception of mutual fund investors as
performance-chasers.